Section 1031 deals have strict guidelines

Question: When you sell a duplex where you live in one unit and the other unit is a rental, do you have to do a 1031 tax-deferred exchange or would part of the duplex be classified as a personal residence?

J.W., Marysville

Answer: The short answer is “yes.” Under tax law, you may sell your principal residence and keep any profits up to $250,000 per person ($500,000 for a married couple) tax-free. No longer do you have to buy a replacement home of equal or greater value to avoid paying capital gains tax. But investment property owners are still subject to the capital gains tax on their property sale profits – unless they exchange the funds into another investment property.

In your case, your duplex is both your primary residence and an investment property. Therefore, from a tax standpoint, you must handle each portion of the property sale separately.

The portion of the duplex that is used for your residence can be sold tax-free, as long as you have owned the property for at least two years and your capital gain does not exceed $250,000. As I explained in this column last month, you can also avoid paying capital gains tax on the rental portion of the duplex by using the Internal Revenue Code Section 1031 exchange procedures. These rules are very strict and they must be followed to the letter, or your capital gains will become taxable. In order to qualify for a 1031 tax-deferred exchange, you must purchase a replacement investment property of equal or greater value than the property you are selling.

In your case, the replacement investment property would only have to be of equal or greater value than the investment portion of your duplex. For example, if your duplex sold for $400,000, with half of the value being allocated to the rental unit, you would have to purchase a replacement investment property that cost $200,000 or more to qualify for the exchange. Another requirement is that the replacement property must be “like kind,” which means it is held for investment or use in a trade or business.

That does not mean that you if sell a duplex you have to buy another duplex. You could replace the duplex with any kind of property, as long as it is held for investment or business use. For example, you could trade up from your duplex into a fourplex or a small apartment building, or you could buy a single-family rental house or even raw land – as long as the purchase price of the replacement investment property is equal to or greater than one-half the sales price of your duplex.

The time limit for completing a tax-deferred exchange is fairly short. You must identify the replacement investment property within 45 days of the closing date on the sale of your duplex and you must close on the purchase of replacement property within 180 days of the closing date on the old property. That doesn’t allow a lot of time for shopping around. Smart investors try to give themselves a little more breathing room by writing in a long escrow period on the sale of their investment property. For example, the purchase and sale agreement might state that the sale shall close 90 days after signing by all parties. That gives the investor an extra three months to locate an acceptable replacement property.

Another important 1031-exchange rule is that the seller cannot have any access to the cash proceeds from the sale of the investment property during the exchange period. This is called “constructive receipt,” and even if the sellers don’t do anything with the money, it is treated as taxable income regardless of whether they buy a replacement property. To avoid this situation, cash from the sale of an investment property in a 1031 exchange is typically held by a neutral third party called an exchange facilitator, who then purchases the replacement investment property on behalf of the exchanger.

The exchange process gets more complicated when you combine investment and residential use in a single property, as in your case. Before signing any agreements to buy or sell an investment property, be sure to consult a tax adviser and an exchange facilitator. Too often, I’ve heard sad stories of investment property sellers who could have saved thousands of dollars in capital gains tax if only they had taken the time to properly structure the transaction as a 1031 tax-deferred exchange before the sale. Once you sell the property and receive the cash, it’s too late to do a 1031 exchange because you have constructive receipt of the sale proceeds.